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BBM2153 | Financial Markets and InstitutionsPrepared by Dr Khairul Anuar

L7: The Stock Market

www. notes638.wordpress.com

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Chapter Preview

In August of 2004, Google went public, auctioning its shares in an unusual IPO format. The shares originally sold for $85 / share, and closed at over $100 on the first day. At the end of 2012, shares are trading on Nasdaq at over $707 / share.

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Chapter Preview

Topics Addressed

─ Stock Market Indexes

─ Buying Foreign Stocks

─ Regulation of the Stock Market

─ Investing in Stocks

─ Computing the Price of Common Stock

─ How the Market Sets Security Prices

─ Errors in Valuation

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Investing in Stocks

1. Represents ownership in a firm

2. Earn a return in two ways

─ Price of the stock rises over time

─ Dividends are paid to the stockholder

3. Stockholders have claim on all assets

4. Right to vote for directors

and on certain issues

5. Two types

─ Common stock

• Right to vote

• Receive dividends

─ Preferred stock

• Receive a fixed dividend

• Do not usually vote

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Investing in Stocks: Sample Corporate Stock Certificate

Figure 13.1 Sapir Consolidated Airlines Stock

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Investing in Stocks: How Stocks are Sold

• Organized exchanges

─ NYSE is best known, with daily volume around 4 billion shares, with peaks at 7 billion.

─ “Organized” used to imply a specific trading location. But computer systems (ECNs) have replaced this idea.

─Others include the ASE (US), and Nikkei, LSE, DAX (international)

─ Listing requirements exclude small firms

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Investing in Stocks: How Stocks are Sold

• Over-the-counter markets

─ Best example is NASDAQ

─ Dealers stand ready to make a market

─ Today, about 3,000 different securities are listed on NASDAQ.

─ Important market for thinly-traded securities—securities that don’t trade very often. Without a dealer ready to make a market, the equity would be difficult to trade.

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Investing in Stocks: Organized vs. OTC

• Organized exchanges (e.g., NYSE)

─ Auction markets with floor specialists

─ 25% of trades are filled directly by specialist

─ Remaining trades are filled through SuperDOT

• Over-the-counter markets (e.g., NASDAQ)

─Multiple market makers set bid and ask prices

─Multiple dealers for any given security

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Investing in Stocks: ECNs

ECNs (electronic communication networks) allow brokers and traders to trade without the need of the middleman. They provide:

• Transparency: everyone can see unfilled orders

• Cost reduction: smaller spreads

• Faster execution

• After-hours trading

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Investing in Stocks: ECNs

However, ECNs are not without their drawbacks:

•Don’t work as well with thinly-traded stocks

•Many ECNs competing for volume, which can be confusing

•Major exchanges are fighting ECNs, with an uncertain outcome

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Investing in Stocks: ETFs

Exchange Traded Funds are a recent innovation to help keep transaction costs down while offering diversification.

• Represent a basket of securities

• Traded on a major exchange

• Index to a specific portfolio (e.g., the S&P 500), so management fees are low (although commissions still apply)

• Exact content of basket is known, so valuation is certain

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Computing the Price of Common Stock

• Valuing common stock is, in theory, no different from valuing debt securities:

─ determine the cash flows

─ discount them to the present

• We will review four different methods for valuing stock, each with its advantages and drawbacks.

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Computing the Price of Common Stock: The One-Period Valuation Model

• Simplest model, just taking using the expected dividend and price over the next year.

•

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Computing the Price of Common Stock: The One-Period Valuation Model

What is the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively? Use a 12% discount rate

Answer:

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Computing the Price of Common Stock: The Generalized Dividend Valuation Model

• Most general model, but the infinite sum may not converge.

•

• Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model.

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Computing the Price of Common Stock: The Gordon Growth Model

• Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is,

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Computing the Price of Common Stock: The Gordon Growth Model

The model is useful, with the following assumptions:

• Dividends do, indeed, grow at a constant rate forever

• The growth rate of dividends, g, is less than the required return on the equity, ke.

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Computing the Price of Common Stock: The Generalized Dividend Valuation Model

• The price earnings ratio (PE) is a widely watched measure of much the market is willing to pay for $1.00 of earnings from the firms.

•

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Computing the Price of Common Stock: The Price Earnings Valuation Method

If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share?

Answer:

Price = 16 $1.13 = $18.08

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How the Market Sets Security Prices

• Generally speaking, prices are set in competitive markets as the price set by the buyer willing to pay the most for an item.

• The buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset.

• Superior information can play an important role.

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How the Market Sets Security Prices

• Consider the following three valuations for a stock with certain dividends but different perceived risk:

• Bud, who perceives the lowest risk, is willing to pay the most and will determine the “market” price.

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Errors in Valuation

Although the pricing models are useful, market participants frequently encounter problems in using them. Any of these can have a significant impact on price in the Gordon model.

• Problems with Estimating Growth

• Problems with Estimating Risk

• Problems with Forecasting Dividends

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Errors in Valuation:Dividend growth rates

Table 13.1 Stock Prices for a Security with D0 = $2.00, ke = 15%, and

Constant Growth Rates as Listed

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Errors in Valuation:Required returns

Table 13.2 Stock Prices for a Security with D0 = $2.00, g = 5%, and Required Returns as Listed

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Errors in Valuation

Security valuation is not an exact science!

Considering different growth rates, required rates, etc., is important in determining if a stock is a good value as an investment.

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Case: The 2007–2009 Financial Crisis and the Stock Market

• The financial crisis, which started in August 2007, was the start of one of the worst bear markets.

• The crisis lowered “g” in the Gordon Growth model - driving down prices.

• Also impacts ke - higher uncertainty increases this value, again lowering prices.

• The expectations were still optimistic at the start of the crisis. But, as the reality of the severity of the crisis was understood, prices plummeted.

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Case: 9/11, Enron and the Market

• Both 9/11 and the Enron scandal were events in 2001.

• Both should lower “g” in the Gordon Growth model - driving down prices.

• Also impacts ke - higher uncertainty increases this value, again lowering prices.

• We did observe in both cases that prices in the market fell. And subsequently rebounded as confidence in US markets returned.

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Stock Market Indexes

• Stock market indexes are frequently used to monitor the behavior of a groups of stocks.

• Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite.

• The securities that make up the (current) DJIA are included on the next slide.

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Stock Market Indexes: The Dow Jones Industrial Average (a)

Table 13.3 The Thirty Companies That Make Up the Dow Jones Industrial Average

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Stock Market Indexes: The Dow Jones Industrial Average (b)

Table 13.3 The Thirty Companies That Make Up the Dow Jones Industrial Average

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Stock Market Indexes

• $1.00 invested in the DJIA back in 1980 (DJIA was around 800) would have grown to about $16.40 in 2012 (Dow closed year at 13,104). This represented an annual growth rate around 8.8%.

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Stock Market Indexes, DJIA (a)

Figure 13.2 Dow Jones Industrial Averages, 1980–2013

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Stock Market Indexes, DJIA (b)

Figure 13.2 Dow Jones Industrial Averages, 1980–2013

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Buying Foreign Stocks

• Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S.

• American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets.

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Regulation of the Stock Market

• The primary mission of the SEC is “…to protect investors and maintain the integrity of the securities markets.”

• The SEC brings around 500 actions against individuals and firms each year toward this effort. This is accomplished through the joint efforts of four divisions.

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Regulation of the Stock Market: Divisions of the SEC

• Division of Corporate Finance: responsible for collecting, reviewing, and making available all of the documents corporations and individuals are required to file

• Division of Market Regulation: establishes and maintains rules for orderly and efficient markets.

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Regulation of the Stock Market: Divisions of the SEC

• Division of Investment Management: oversees and regulates the investment management industry

• Division of Enforcement: investigates violations of the rules and regulations established by the other divisions.

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Chapter Summary

• Investing in Stocks: we developed an understanding the structure of the various trading systems, including exchanges and OTC markets

• Computing the Price of Common Stock: various techniques for valuing dividends and earnings were presented

• How the Market Sets Security Prices: the basic idea that prices are set by the “highest bidder” was reviewed

• Errors in Valuation: difficulties in determining dividends, growth rates, and/or required returns can have a significant impact in the pricing models

• Stock Market Indexes: a way to track changes in valuation for a broad group of stocks

• Buying Foreign Stocks: potential benefits for diversifications, simplified by the use of ADRs.

• Regulation of the Stock Market: the primary function of the Securities and Exchange Commission